Berenson the number; how the drive for quarterly earnings corrupted wall street and corporate america (2003)

Contents Title Page Dedication Epigraph Prologue: One of Many Introduction: System Failure Part I That Was Then Chapter 1: Boom and Bust Chapter 2: Foundations Chapter 3: Bubbling Under Chapter 4: The Death of Equities Part II This Is Now Chapter 5: Countdown Chapter 6: The Number Is Born Chapter 7: Options Chapter 8: Accountants at the Trough Chapter 9: Archaeologists and Detectives Chapter 10: Frenzy Chapter 11: Truth Conclusion: Look Both Ways Appendix 1: Accrual Versus Cash Accounting Appendix 2: Balance Sheets and Income Statements Notes Endnotes Acknowledgments About the Author Copyright Page FOR MY BROTHER DAVID, A TRUE FRIEND It is difficult to get a man to understand something when his salary depends on his not understanding it UPTON SINCLAIR Prologue One of Many January 22, 2001, 5:30 P.M Darkness has settled over the East Coast, but the mood is sunny in the executive suites at the Islandia, New York, headquarters of Computer Associates The world’s fourth-largest independent software company has just released its quarterly earnings for the three months ending December 2000, and the report is a good one Sales and profits are higher than Wall Street anticipated No one will benefit from the news more than Charles Wang, the chairman of Computer Associates, and Sanjay Kumar, the company’s chief executive, good friends who have just bought the New York Islanders professional hockey team Wang owns 30 million shares, more than $1 billion, of the company’s stock Kumar, a relative pauper, has about $200 million in Computer Associates shares Those fortunes will grow the next day, as investors bid Computer Associates’ stock up almost percent After issuing the report, Computer Associates holds a conference call to discuss its results with the Wall Street analysts who follow the company Kumar can’t resist bragging Although the software industry is in its worst downturn in a decade, his company has demonstrated its strength “We’re extremely pleased with the performance we pulled off,” he says.1 If she had been on the call, that news would have come as a surprise to Mary Welch Welch, a Computer Associates sales rep, had been fired by the company a week earlier, one of three hundred employees laid off as 2001 began Like most of the fired employees, Welch was told she would not receive any severance pay, because she had been dismissed for poor performance Yet she had received a positive job review only two weeks before Welch and many other fired employees believed that Computer Associates wanted to avoid paying severance by disguising a company-wide cutback as individual firings The layoffs were necessary because the company’s sales had plunged in the December quarter, the fired employees claimed “They did a mass layoff,’’ Welch said At the time, Welch’s complaints seemed nothing more than the gripes of a disgruntled exemployee After all, Computer Associates’ financial statements showed that business had been better than ever in the December quarter, with sales up 13 percent and profit up almost one-third Surely the company couldn’t just make up its results But Mary Welch was right Thanks to an audacious accounting trick, Computer Associates had found a way to rewrite its financial statements The company had divorced the reality of its business, a business in decline, from the profit-and-loss picture it presented to Wall Street Breaking the most basic conventions of accounting, it was rebooking sales and earnings that it had already reported Computer Associates was not a penny stock operating in the shadows of the market It had eighteen thousand employees, tens of thousands of shareholders, and a market value of more than $20 billion, more than Nike or Federal Express Yet no one—not the analysts paid to decipher the truth of Computer Associates’ fortunes, not the accountants legally required to certify its books, not the mutual fund managers who bought its stock, and most certainly not the regulators who oversaw the U.S securities markets—had blown the whistle on the company’s accounting maneuvers There are fourteen thousand publicly traded companies in the United States Expecting all of them to be honest is unrealistic Like any town of fourteen thousand, the market is bound to have its share of grifters and shoplifters But the deception at Computer Associates was dangerous precisely because it wasn’t an aberration By January 2001, all manner of companies were abusing accounting rules to mislead their investors, seemingly without fear of being caught A strange madness had gripped the market Even its most solid citizens were running red lights and breaking windows And the police were nowhere in sight Introduction System Failure On Wall Street, not all numbers are created equal New home starts The consumer confidence index Retail sales Overnight television ratings Unemployment claims PC shipments Casino winnings in Atlantic City and the Las Vegas Strip The figures roll out every day from government agencies and industry trade groups and independent analysts Watching them all is impossible; most speed by unnoticed But one set of numbers burns brighter than the rest Every three months, publicly traded United States companies report their sales and profits to their shareholders Those quarterly announcements are the lodestar that investors—and these days, that’s most of us—use to judge the health of corporate America It makes intuitive sense that corporations must regularly tell their shareholders how much money they have made or lost What’s your weekly paycheck? Did you get a bonus last year? All in all, how much money did you make? You know the answer, without much trouble Why shouldn’t Exxon and General Motors? They should, and they Every quarter they add up their sales and costs, and figure out where they stand Then they tell the world, in press releases and conference calls and most important in reports that they file four times a year with the Securities and Exchange Commission, the federal agency that regulates U.S stock markets To be precise: Three quarterly reports, or 10-Qs, submitted to the S.E.C within forty-five days after a quarter ends One 10-K, the big one, the audited annual report, to be filed less than ninety days of the end of a company’s fiscal year Qs and Ks, in Wall Street shorthand Qs and Ks are monuments to numbers Revenue Selling, general, and administrative expenses Operating income Interest paid Columns of huge numbers, eight, nine, or ten figures long, fall down the page in black and white to land with a bang disguised as a whimper at one small number: earnings per share Earnings per share is usually no more than a couple of bucks, an unprepossessing sum compared to the giant figures above But its small size is deceiving Multiply a dollar or two per share by hundreds of millions of shares, and you have real money A stray penny on the 10 billion shares that General Electric has outstanding turns out to be $100 million Even within a profit report, not all numbers are equal For traders and investors of all sizes, earnings per share is the ultimate benchmark of a company’s success or failure Has it risen from the previous quarter and the previous year? Has it met the “consensus”—the average estimate of the Wall Street analysts who follow the company? More than any other number, earnings per share determines whether a company’s shares will rise or fall, whether its chief executive will be rewarded or fired, whether it will build a new headquarters or endure a round of layoffs On Wall Street, a place of little subtlety, earnings per share is known simply as “the number.” As in “What was the number for Pfizer?” Earnings per share is the number for which all the other numbers are sacrificed It is the distilled truth of a company’s health Earnings per share is the number that counts Too bad it’s a lie Under the best of circumstances, the figures in a quarterly report—earnings per share most of all—are approximations, best guesses based on a thousand other best guesses Earnings reports are about accounting, and the accounting that big companies use to measure their financial health has as much in common with the way you balance your checkbook as a five-alarm fire has with a backyard barbecue If you’re like most people, your paycheck is your main source of income Over the last few years, if you work for a publicly traded company, you may have gotten some stock options too Those are nice, but the local grocery store prefers cash, so if you’re wise, you won’t figure options as income, either, until you cash them in Then there’s the other side of the ledger: spending and saving The distinction is usually clear, although the line blurs at your mortgage payment, since part of that is going to build equity in your home Still, your personal accounting is relatively straightforward You can easily compare how much you’ve earned and how much you’ve spent, because you get paid in cash and you spend cash (or use a credit card, which you pay off within a few weeks) But big companies measure their costs and revenues in a very different way Instead of simply counting the cash they are making and spending, they use something called “accrual accounting.” Under accrual accounting, a company books revenue when it makes a sale, not when it actually receives the cash for the sale It books an expense when it agrees to buy something, not when it actually pays Accrual accounting also recognizes that companies invest in assets that will last many years, and it allows the companies to spread the cost of those assets over their life For example, an airline doesn’t expense the entire price of a new plane up front Instead, it recognizes the cost of the plane over many years, as the aircraft’s value “depreciates.” In theory, accrual accounting makes sense Cash accounting can make companies appear to be losing money just when their business is ramping up and they’re making lots of sales for which they’ll be paid in the future.*1 But what makes sense in theory can be abused in practice Because they’re not simply measuring cash inflows and outflows, companies need to make hundreds of assumptions to calculate their earnings each quarter They must estimate everything from how much money they will earn on their pension funds to how quickly their assets will lose value.†2 With so many assumptions to make, even honest companies sometimes make mistakes Those that want to cheat have an almost infinite number of ways to so They can book sales to customers who won’t ever be able to pay them They can hide ongoing, day-to-day expenses as investments in long-lived assets They can shift research and development expenses to supposedly independent partners They can make sham deals with other companies, swapping overvalued assets in a way that allows both sides to book a profit on the trade Used properly, accrual accounting is about timing, not about creating profits where none exists Over the long run, the profits that a company reports under accrual accounting should jibe with the cash it receives and spends Over the long run, companies that make sales to customers who can’t pay will have to admit that their clients are deadbeats Over the long run, a company can’t hide operating expenses as capital spending, because it will wind up with a balance sheet full of nonexistent assets Over the long run, all the accounting and financial tricks in the world can’t turn a failing business into a success But they can in the short run And sometimes, with enough tricks, the short run can last a long time, long enough for executives to make tens or even hundreds of millions of dollars selling stock whose value has been inflated by pumped-up earnings Given the importance of the number, and the ease with which it can be manipulated, you might expect that investors would look at earnings per share with a skeptical eye You might think they would carefully read the footnotes buried at the bottoms of Qs and Ks, and examine a company’s cash flows to see whether its profits have any basis in reality But you’d be wrong As a rule, before 2002, most individual and professional investors didn’t worry much about accounting As long as a major accounting firm certified that a company’s financial statements were prepared according to GAAP, or “generally accepted accounting principles,” shareholders took them at face value Investors held as an article of faith that the quality of corporate financial reporting in the United States was better than anywhere else Watched over by the Securities and Exchange Commission and independent accountants, American companies had no choice but to tell Wall Street the truth U.S markets were the fairest and most honest in the world Like most deeply held beliefs, this shibboleth overlooked inconvenient realities The S.E.C had never been given a budget large enough to check every financial statement for irregularities Accountants had always had to balance their responsibilities to investors with their paychecks, which came from the companies whose books they audited Still, if history was any guide, investors had reason to be confident The combination of mandatory corporate disclosure and federal oversight seemed to have worked since its creation in 1934 Sure, the concept behind the number—that public companies could precisely calculate their earnings each quarter—was a lie But as long as companies prepared their financial statements in good faith, it was a white lie Companies might not always be able to calculate their profits exactly, but if they made honest estimates they ought to be close And for two generations they had been close Aggressive accounting gimmickry had been uncommon, and overt fraud rare Most financial statements were reasonably accurate There had been exceptions, especially during the 1960s, but they never caused investors to question the markets’ overall integrity In fact, in some important ways, markets appeared to be growing fairer as the twentieth century progressed Outright manipulation of individual stocks faded, and the S.E.C aggressively pursued insider trading cases But as the bull market of the 1990s turned into a boom and then a bubble, a few regulators, shortsellers, and journalists warned that the accuracy of corporate financial statements, the core of the system, was slipping Accounting gimmickry had grown widespread and increasingly dangerous, they complained The number of earnings restatements soared in the late 1990s, and several big public companies admitted or were caught committing accounting fraud “We are witnessing an erosion in the quality of earnings and, therefore, the quality of financial reporting Managing may be giving way to manipulation; integrity may be losing out to illusion,” Arthur Levitt, chairman of the S.E.C., said in a prophetic 1998 speech in New York “Today, 26 Ann B Fisher, “Can You Trust Analysts’ Reports?” Fortune, October 1, 1990, p 195 Raymond L Dirks and Leonard Gross, The Great Wall Street Scandal, McGraw-Hill, 1974, p 256 Michael Siconolfi, “Under Pressure: At Morgan Stanley, Analysts Were Urged to Soften Harsh Views,” The Wall Street Journal, July 14, 1992, p A1 Jeffrey M Laderman, “How Much Should You Trust Your Analyst?” Business Week, July 23, 1990, p 54 Nocera, “Picking the Winners,” p 26 Siconolfi, “Under Pressure,” p A1 10 Fisher, “Can You Trust Analysts’ Reports?” p 195 11 N R Kleinfield, “The Many Faces of the Wall Street Analyst,” The New York Times, October 25, 1987, p C1 12 Stuart Weiss, “Hell Hath No Fury Like a Surprised Stock Analyst,” Business Week, January 21, 1985, p 98 13 Bill Barnhart, “Blood, Sweat, Tears, and a Few Pennies,” Chicago Tribune, October 31, 1994, p C1 CHAPTER 7: OPTIONS “For Whom Were the Golden Eighties Most Golden?” Business Week, May 7, 1990, p 60 Warren Buffett, “Who Really Cooks the Books,” The New York Times, July 24, 2002, p A19 From an unpublished letter by Graham that Buffett quoted in his 1990 letter to Berkshire Hathaway shareholders World Accounting Report, Financial Times, April 11, 1994 “For Whom Were the Golden Eighties Most Golden?” p 60 Justin Fox, “The Next Best Thing to Free Money,” Fortune, July 7, 1997, p 52 J Carter Beese, “A Rule That Stunts Growth,” The Wall Street Journal, February 4, 1994, p A18 “Big Six Accounting Firms Urge FASB Chairman to Withdraw Stock Option Plan,” Securities Week, July 25, 1994, p Justin Fox, “The Next Best Thing to Free Money,” p 52 10 Ibid 11 David Leonhardt, “Stock Options Said Not to Be as Widespread as Backers Say,” The New York Times, July 18, 2002, p C1 12 Fox, “The Next Best Thing to Free Money,” p 52 13 David Leonhardt, “Why Is This Man Smiling? Executive Pay Drops Off the Political Radar,” The New York Times, Week-in-Review, April 16, 2000, p 14 Peter G Gosselin, “Fed Official Urges Execs to Trim Their Pay,” Los Angeles Times, September 12, 2002, p C1 15 Leonhardt, “Why Is This Man Smiling?” p 16 Gretchen Morgenson, “As Pressure Grows, Option Costs Come Out of Hiding,” The New York Times, Money and Business, May 19, 2002, p 17 Roger Lowenstein, “Heads I Win, Tails I Win,” The New York Times Magazine, June 27, 2002, p 102 CHAPTER 8: ACCOUNTANTS AT THE TROUGH Mark Stevens, The Big Eight, Macmillan Publishing Company, 1981, pp 23–24 Ibid., p 31 Ibid., p 42 Previts and Merino, A History of Accountancy in the United States, p 372 Stevens, The Big Eight, p Ibid., p 62 Lee Berton, “Total War: CPA Firms Diversify, Cut Fees, Steal Clients in Battle for Business,” The Wall Street Journal, September 20, 1985 p A1 Flynn McRoberts et al., “The Fall of Andersen: Greed Tarnished Golden Reputation,” Chicago Tribune, September 1, 2002, p McRoberts et al., “Civil War Splits Andersen: Consulting Conquers, Traditions Wither,” Chicago Tribune, September 2, 2002, p 10 Stevens, The Big Six, Touchstone, 1991, p 210 11 Ibid., p 210 12 Jill Andresky, “But I’m Just the Piano Player (Laventhol & Horwath),” Forbes, May 4, 1987, p 56 13 Stevens, The Big Six, p 21 14 McRoberts et al., “The Fall of Andersen.” 15 Emily Nelson and Joann S Lublin, “Buy the Numbers,” The Wall Street Journal, August 13, 1998, p A1 16 Floyd Norris, “Market Place: Cendant’s Share Price Plunges 46% on ‘Accounting Irregularities,’” The New York Times, April 17, 1998, p D1 17 Silverman’s quotes in footnote: Reed Abelson, “The Road to Reviving a Reputation: Cendant Chief Tries to Recover from a Deal Gone Very Bad,” The New York Times, June 15, 2000, p D1 18 Floyd Norris, “Editorial Observer: Wall Street Turns Hostile to Chainsaw Al,” The New York Times, June 3, 1998, p A24 19 Reed Abelson, “Market Place: As the Accounting World Shifts, Conflicts Are Items to Audit,” The New York Times, November 25, 1997, p D10 20 Melody Petersen, “Consulting by Auditors Stirs Concern,” The New York Times, July 13, 1998, p D1 21 Arthur Levitt, Take On the Street, Pantheon Books, 2002, p 128 22 Statistics from Opensecrets.org, an Internet site that compiles data on political contributions 23 Jane Mayer, “The Accountants’ War,” The New Yorker, April 22, 2002, p 70 24 Floyd Norris, “A War the Accountants Will Lose Even If They Win,” The New York Times, July 28, 2000, p C1 25 Mayer, “The Accountants’ War,” p 72 CHAPTER 9: ARCHAEOLOGISTS AND DETECTIVES Arthur Levitt, “The Numbers Game,” speech before New York University’s Center for Law and Business, September 28, 1998 SEC Operations: Increased Workload Creates Challenges, General Accounting Office, March 2002, p 3 Securities and Exchange Commission: Human Capital Challenges Require Management Attention, General Accounting Office, September 2001, p 24 Ibid., p 18 Ibid., p SEC Operations: Increased Workload, General Accounting Office, p 23 Ibid., p 19 Scot J Paltrow, Greg Ip, and Michael Schroeder: “Beat Cop: As Huge Changes Roil the Market, Some Ask: Where Is the SEC?” The Wall Street Journal, October 11, 1999, p A1 Herb Greenberg, “Herb’s Hotline: A Swift Response from Dan Borislow,” TheStreet.com, December 12, 2000 10 Joel Seligman, The Transformation of Wall Street, Houghton Mifflin Company, 1982, p 565 11 Ibid., p 568 12 Floyd Norris, “3 Big Accounting Firms Assail S.E.C.’s Proposed Restrictions,” The New York Times, July 27, 2002, p C9 13 Marshall E Blume and Irwin Friend, The Changing Role of the Individual Investor, John Wiley & Sons, 1978, p 203 14 Jerry Knight, “GOP Begins Bid to Revamp Securities Laws,” The Washington Post, July 19, 1995, p F1 15 Roger Lowenstein, “House Aims to Fix Securities Laws, But Indeed, Is the System Broke?” The Wall Street Journal, August 10, 1995, p C1 16 Michael Schroeder, “Guess Who’s Gunning for the S.E.C,” Business Week, August 14, 1995, p 40 17 Paltrow, Ip, and Schroeder, “Beat Cop.” 18 Jane Mayer, “The Accountants’ War,” p 66 19 Michael Lewis, “Jonathan Lebod’s Extracurricular Activities,” The New York Times Magazine, February 25, 2001, p 25 20 Clifton Leaf, “It’s Time to Stop Coddling White-Collar Crooks Send Them to Jail,” Fortune, March 18, 2002, p 66 21 Ibid., p 64 22 Dean Rotbart, “Market Hardball: Aggressive Methods of Some Short Sellers Stir Critics to Cry Foul,” The Wall Street Journal, September 9, 1985, p A1 23 Gary Weiss, “Sure-Shot Shorts: Short Sellers Are Hitting the Right Stocks at the Right Time,” Business Week, November 16, 1992, p 101 24 E S Browning, “Short Sellers Lose Big, but Some Say Their Day Is Due,” The Wall Street Journal, November 2, 1995, p A1 CHAPTER 10: FRENZY Molly Baker, “Pixar IPO Underscores Changes in the IPO World,” The Wall Street Journal, December 11, 1995, p C1 Craig Torres, “Pricing of Hot Stock Offerings Sparks Concerns,” The Wall Street Journal, March 4, 1992, p C1 Molly Baker and Joan E Rigdon, “Netscape’s IPO Gets an Explosive Welcome,” The Wall Street Journal, August 9, 1995, p C1 Joan E Rigdon, “Netscape’s Market for Future Growth May Not Be Big Enough for Wall Street,” The Wall Street Journal, August 11, 1995, p A3 Baker and Rigdon, “Netscape’s IPO Gets an Explosive Welcome,” p C1 Reed Abelson, “A Guide to the Goofs of Wall Street’s Wizards,” The New York Times, December 1, 1996, p C1 Gretchen Morgenson, “How Did So Many Get It So Wrong?” The New York Times, December 31, 2001, p C1 Floyd Norris, “Stormy Weather?” The New York Times, January 2, 1997, p C21 Securities Industry Association 2002 fact book, p 49 10 David Barboza, “On-Line Trade Fees Falling Off the Screen,” The New York Times, March 1, 1998, p C4 11 Gregory J Millman, The Day Traders: The Untold Story of the Extreme Investors and How They Changed Wall Street Forever, Times Books, 1999, p 29 12 Matthew Klam, “Riding the Mo in the Lime Green Glow,” The New York Times Magazine, November 21, 1999, p 70 13 Securities Industry Association fact book, p 58 14 Investment Company Institute Mutual Fund fact book, p 3, section 15 Suzanne McGee, “Quest for Security: Money Managers Seek Places to Park Cash Until Market Calms,” The Wall Street Journal, January 19, 1998, p C1 16 Diane K Shah, “Riding the Bull for a Day,” The New York Times Magazine, December 1, 1996, p 99 17 Statistics courtesy of Barra, a financial risk management company based in Berkeley, California 18 Jeffrey Bronchick, “We Need Better Stock Analysis, Not More Info,” The Wall Street Journal, August 6, 2002, p A20 19 Christopher Oster and Ken Brown, “First Call Changes Last Word on Earnings,” The Wall Street Journal, August 22, 2002, p C1 20 Joan E Rigdon, “H-P Posts 25% Net Gain, but Stock Falls Due to Missed Forecasts,” The New York Times, May 17, 1996, p A3 21 Greg Ip, “Traders Laugh Off the Official Estimate on Earnings, Act on Whispered Number,” The Wall Street Journal, January 17, 1997, p C1 22 Jack Ciesielski, “More Second Guessing: Markets Need Better Disclosure of Earnings Management,” Barron’s, August 24, 1998, p 47 23 Nanette Byrnes and Richard A Melcher, “Earnings Hocus-pocus—How Companies Come Up with the Numbers They Want,” Business Week, October 5, 1998, p 134 24 Bernard Condon, “Pick a Number, Any Number,” Forbes, March 23, 1998, p 124 25 Jesse Eisinger, “Why Accounting Matters,” TheStreet.com, September 21, 1998 26 Condon, “Pick a Number,” p 124 27 David Wessel and Jacob M Schlesinger, “Fed Cuts Interest Rates a Quarter-Point in a Surprise Move to Shore Up Markets,” The Wall Street Journal, October 16, 1998, p A3 28 George Melloan, “Global View: Fed’s Silver Lining Hides Some Clouds,” The Wall Street 29 30 31 32 33 34 35 36 37 38 39 Journal, November 24, 1998, p A23 Steve Johnson, “These Days, TV Is Bullish on Business,” Chicago Tribune, January 24, 2000, p T1 Susan Pulliam, “At Bill’s Barber Shop, In Like Flynn Is a Cut Above the Rest,” The Wall Street Journal, March 13, 2000, p A1 Maria Atanasov, “Share and Share Alike,” Newsday, August 30, 2000, p C8 Floyd Norris, “The Year in the Markets, 1999: Extraordinary Winners and More Losers,” The New York Times, January 3, 2000, p C17 Greg Ip, “High Anxiety: Techs Keep Rising Despite Fears—Dow Industrials, Nasdaq Ascend to New Peaks,” The Wall Street Journal, December 27, 1999, p C1 Shawn Tully, “Has the Market Gone Mad?” Fortune, January 24, 2000, p 80 Robert D Hershey Jr., “Down and Out on Wall Street,” The New York Times, December 26, 1999, p C1 Stacey I Bradford, “The Future Is Now,” SmartMoney, February 2000, p 106 James J Cramer, “The Winners of the New World,” TheStreet.com, February 29, 2000 Statistics courtesy of Thomson First Call, which compiles analysts’ estimates Andrew Marks, “Nasdaq Express Just Rolls On and On,” Business Times (Singapore), March 11, 2000, p CHAPTER 11: TRUTH Alex Berenson and Patrick McGeehan, “Amid the Stock Market’s Losses, a Sense the Game Has Changed,” The New York Times, April 16, 2000, p A1 Alex Berenson and Kevin Petrie, “Cracking the Books II: Lucent’s Growing Fast but Desperate to Keep Up with the Ciscos,” TheStreet.com, October 18, 1999 Simon Romero, “Compressed Data; Lucent to Sell Its Golf Complex at a Profit,” The New York Times, July 30, 2001, p C4 Seth Schiesel, “New Warning, and Deeper, from Lucent,” The New York Times, July 21, 2000, p C1 Justin Baer, “Lucent Inflated Sales, Hurting Future Revenue, Executives Said,” Bloomberg News, November 20, 2002 Mark Maremont, Jesse Eisinger, and John Carrerou, “Muffled Voice: How High-Tech Dream at Lernout & Hauspie Crumbled in Scandal,” The Wall Street Journal, December 7, 2000, p A1 Ibid John Markoff, “Cisco Results Come In Short of Forecast,” The New York Times, February 7, 2001, p C1 Susan Pulliam, “Hair Today, Gone Tomorrow: Tech Ills Shave Barber,” The Wall Street Journal, March 7, 2001, p C1 10 Bethany McLean, “Enron’s Power Crisis,” Fortune, September 17, 2001, p 48 11 David Cay Johnston, “A 1995 Executive Pay Plan Led to Big Bonus This Week,” The New York Times, May 23, 1998, p D15 12 Raju Narisetti, “CA’s CEO Vows Growth Prospects Remain Strong,” The Wall Street Journal, August 12, 1998, p B6 13 Computer Associates press release, PR Newswire, October 25, 2000 14 Jerry Guidera, “Nobody Is Too Sure Why Charles Wang Is Buying Up a Village,” The Wall Street Journal, June 27, 2001, p A1 15 Jesse Drucker, “Motorola’s Profit: Special Again?” The Wall Street Journal, October 15, 2002, p C1 16 Jonathan Weil, “Deals and Deal Markets: Pro Forma Figures May Stay in Reports, but Must Be Explained, Panel Suggests,” The Wall Street Journal, April 27, 2001, p C16 17 Mark Harrington, “Upbeat Report for CA: A Rise in Earnings,” Newsday, January 23, 2001, p A36 18 Bethany McLean, “Is Enron Overpriced?” Fortune, March 5, 2001, p 122 19 Laura Goldberg, “Enron Posts Loss After Writedowns; Core Businesses Considered Solid,” Houston Chronicle, October 17, 2001, p 20 Susanne Craig and Jonathan Weil, “Most Analysts Remain Plugged In to Enron,” The Wall Street Journal, October 26, 2001, p C1 21 Bethany McLean, “Why Enron Went Bust,” Fortune, December 24, 2001, p 58 22 Leslie Wayne, “Before Debacle, Enron Insiders Cashed in More than $1.1 Billion in Shares,” The New York Times, January 13, 2002, p A1 23 Floyd Norris and David Barboza, “Ex-Chairman’s Finances: Lay Sold Shares for $100 Million,” The New York Times, February 16, 2002, p A1 24 Joe Berardino, “Enron: A Wake-Up Call,” The Wall Street Journal, December 4, 2001, p A18 25 Michael Rapoport, “In the Money: Enron Auditor’s Complaints Don’t Wash,” Dow Jones News Service, December 4, 2001 26 Flynn McRoberts et al., “Ties to Enron Blinded Andersen: Firm Couldn’t Say No to Prized Client,” Chicago Tribune, September 3, 2002, p 27 Kurt Eichenwald, “Andersen Misread Depths of the Government’s Anger,” The New York Times, March 18, 2002, p A1 28 Richard L Berke and Janet Elder, “Poll Finds Enron’s Taint Clings More to G.O.P than Democrats,” The New York Times, January 27, 2002, p A1 29 Jeff Gerth and Richard W Stevenson, “Bush Calls for End to Loans of a Type He Once Received,” The New York Times, July 11, 2002, p A1 30 David E Sanger and David Barboza, “In Shift, Bush Assails Enron over Handling of Collapse,” The New York Times, January 23, 2002, p A1 31 Michael Schroeder, “As Pitt Launches S.E.C Probe of Himself, Criticism Mounts,” The Wall Street Journal, November 1, 2002, p A1 32 Floyd Norris, “The Big Five Comment on Accounting Practices and the Fall of Enron,” The New York Times, December 5, 2001, p C1 33 Samuel DiPiazza and Robert Eccles, Building Public Trust: The Future of Corporate Reporting, John Wiley & Sons, 2002, p 156 34 Ibid., p 100 35 “The Top 25 Managers of the Year,” Business Week, January 14, 2002 36 Gretchen Morgenson, “As It Beat Profit Forecast, I.B.M Said Little About Sale of a Unit,” The New York Times, February 15, 2002, p C1 37 Gretchen Morgenson, “Wait a Second: What Devils Lurk in the Details,” The New York Times, April 14, 2002, p C1 38 Alex Berenson, “Tweaking Numbers to Meet Goals Comes Back to Haunt Executives,” The New York Times, June 29, 2002, p A1 39 “Financial Statement Restatements: Trends, Market Impacts, Regulatory Responses, and Remaining Challenges,” General Accounting Office, October 2002, p 17 40 Statistics from Bloomberg analytics, a data service for professional investors 41 Steven Labaton and Richard A Oppel Jr., “Testimony from Exxon Executives Is Contradictory,” The New York Times, February 8, 2002, p A1 42 Floyd Norris, “Enron’s Many Strands: The World According to Enron’s Ex-Chief,” The New York Times, February 27, 2002, p C1 43 E S Browning, “Main Street Loses Faith in Buying Stock at Last,” The Wall Street Journal, May 7, 2002, p A1 44 Simon Romero and Alex Berenson, “WorldCom Says It Hid Expenses, Inflating Cash Flow $3.8 Billion,” The New York Times, June 26, 2002, p A1 45 Jesse Eisinger, “The Power of Analysts Is Still Strong on Street,” The Wall Street Journal, September 9, 2002, p C1 46 Randy Whitestone, “Investors Lose Interest in U.S Stocks as Shares Fall,” Bloomberg News, July 11, 2002 47 David E Sanger, “Corporate Conduct: Bush, on Wall St., Offers Tough Stance,” The New York Times, July 10, 2002, p A1 48 Richard A Oppel Jr., “Corporate Conduct: Bush and Democrats Still Deeply Split on What Needs to Be Done,” The New York Times, July 9, 2002, p C5 49 Elisabeth Bumiller, “Corporate Conduct: Bush Signs Bill Aimed at Fraud in Corporations,” The New York Times, July 31, 2002, p A1 50 Stephen Labaton, “Bitter Divide as Securities Panel Picks an Accounting Watchdog,” The New York Times, October 26, 2002, p A1 51 Ibid 52 Stephen Labaton, “Bush Tries to Shrink S.E.C Raise Intended for Corporate Cleanup,” The New York Times, October 19, 2002, p A1 53 Stephen Labaton, “Can a Bloodied S.E.C Dust Itself Off Now and Get Moving?” The New York Times, December 16, 2002, p C2 54 Arthur Levitt, Take On the Street, Pantheon Books, 2002, p 236 CONCLUSION: LOOK BOTH WAYS Michael Lewis, “The Vilification of the Money Class (and the Triumph of the Mob),” The New York Times Magazine, October 27, 2002, p 94 Jeremy J Siegel, Stocks for the Long Run: Third Edition, McGraw-Hill, 2002, p 113 Statistics courtesy of Thomson First Call Jerome Lawrence and Robert E Lee, Inherit the Wind, Random House, 1955, p 96 Endnotes *1 For an example of why accrual accounting makes more sense than cash accounting to measure big companies’ results, see Appendix †2 It may seem odd that companies can’t know for certain something as basic as how quickly their assets will lose value But consider this example: You and your neighbor buy identical new cars on the same day You take good care of your car, regularly changing its oil and putting it in garages instead of parking it on the street so it doesn’t get scratched Your neighbor is much less conscientious Three years later you have spent $1,000 more maintaining your car than your neighbor But you figure that your car is worth $2,000 more than your neighbor’s, because it’s in better shape The way you see it, you’ve saved $1,000 Your neighbor disagrees He thinks the cars are worth the same He thinks you’ve wasted $1,000 on unnecessary maintenance Who’s right? You may not be able to tell until the cars are sold But if you were a public company, you would have to estimate your car’s value every three months— and so would your neighbor And those estimates would play an important part in determining your quarterly “earnings.” Now, imagine that instead of owning one car, you own thousands of garbage trucks If you underestimate how quickly those assets are losing value, either accidentally or deliberately, you will wind up overestimating your earnings And it will be essentially impossible, until you actually sell the used trucks, for anyone to know what you’ve done *3 Essentially, an investor who buys on margin is borrowing part of the purchase price from his broker If the stock rises, the investor’s gains are multiplied, but if it falls even a little, the investor can face a “margin call” and be forced to put up more cash as collateral If he can’t, the broker can sell the stock—without the investor’s consent—and use the proceeds to repay the loan As a result, heavy margin borrowing can worsen market crashes, because it can result in forced selling at times when stocks are already falling *4 Short-sellers borrow stock and sell it, hoping to buy it back later for a lower price and profit from the decline A short squeeze occurs when many shorts are simultaneously forced to return the stock they have borrowed, or “cover” their short positions If there are not enough shares outstanding for the shorts to close out their positions, they can be forced into a ruinous bidding war for the few shares of stock that are available In a full-blown squeeze, a stock’s price can rise 50 or 100 points in a day *5 Balance sheets and income statements are the two most important pieces of financial information available to a company’s shareholders The balance sheet explains a company’s overall financial health It reveals how much cash is available, the overall value of the company’s assets, and how much of that value is available for shareholders after subtracting the company’s debts and other liabilities The income statement explains how much money the company has made or lost over a specific period of time—usually either three months or a year It details sales and expenses, which are generally broken into several categories, including taxes, interest, and overhead costs What’s left is the profit—or loss—available to shareholders for the period For more information on balance sheets, see Appendix *6 Corporate governance is the boring but very important discussion of the way companies are run The structure of public companies inevitably creates a gap between the people who own a company’s assets, a.k.a shareholders, and the people who control those assets, a.k.a executives The trick is to make sure that executives act in the interest of shareholders Unfortunately, without a large block of shares, no single shareholder has the power to hold executives accountable Over the years, governance experts have suggested various solutions to this problem, such as giving executives lots of stock options so their financial interest is theoretically aligned with that of the company Unfortunately, the fixes have often made matters worse (More on this in Chapters and 7.) *7 Book value is the value of a company’s assets as stated on its balance sheet, after deducting liabilities In theory, book value represents the amount of money likely to be available to shareholders should a company be liquidated In reality, companies are not usually liquidated unless they are losing money and have no prospect for a turnaround—and under those circumstances, their assets usually sell for much less than the values at which they are listed on the company’s book Even so, book value is an important measure of a company’s worth *8 Suppose Conglomerate XYZ has net income of $10 million, with 10 million shares outstanding, for earnings of $1 a share Suppose also that it has a price-earnings ratio of 40, a price of $40, and a total market value of $400 million Its target is Company ABC, which also has income of $10 million, 10 million shares outstanding, and earnings of $1 a share But ABC has a price-earnings ratio of only 15, a price of $15, and a market value of $150 million XYZ buys ABC for $20 a share in an all-stock deal, issuing 0.5 share of XYZ stock for each share of ABC stock Presto! The new XYZ-ABC now has 15 million shares of stock outstanding and earnings of $20 million, or earnings of $1.33 a share Without making its business more efficient, XYZ has increased its per-share earnings by 33 percent If its stock follows, XYZ will rise to $53.33, thanks to the simple magic of acquisition accounting *9 The AICPA was the successor to various industry trade groups Accountants like creating, merging, and disbanding trade groups almost as much as they like legal disclaimers *10 The Big Eight were the eight major accounting firms that dominated the profession from the 1960s through the late 1980s: Arthur Andersen, Arthur Young, Coopers & Lybrand, Ernst & Whinney, Deloitte Haskins & Sells, Peat Marwick, Price Waterhouse, and Touche Ross *11 The heaviest day ever had come a year earlier when Joe Granville, at the time one of Wall Street’s best-known stock strategists, told his clients to “sell everything.” During the 1970s, Granville became famous for the accuracy of his bearish calls; unfortunately, he never accepted that the bear market had ended For the next two decades, as stocks soared, he would prophecy doom again and again, becoming little by little the market’s cranky, slightly unhinged uncle *12 Federal tax rules also encouraged raiders to load up on debt and skimp on equity Interest payments on debt were (and are) a pre-tax expense for companies, while dividend payments on stock come out of after-tax income Raiders argued that in the early 1980s many companies were “underleveraged,” with too little debt and too much equity As a result, they paid more in taxes than they needed to *13 It is harder to defend management-led buyouts, where CEOs bought out their own shareholders with borrowed money In those cases, executives essentially profited from their own incompetence If they really knew how to run their companies more efficiently, they should have done so before their buyouts on behalf of all their shareholders—not afterward for their own benefit It is also hard to defend “greenmail,” the practice of a raider taking a minority stake in a company and then demanding that he be bought out at a premium to its market price in return for his agreement not to start a takeover fight In that case, the only beneficiary is the raider, who makes a few million dollars and disappears, leaving the company’s previous shareholders no better off than they were before *14 Of course, a company can also borrow the money to pay its dividends—if it can find a willing lender But that trick is unlikely to work for more than a couple of quarters In the long run, banks and bondholders will look hard at a company that isn’t generating enough cash to meet its dividend requirements *15 Interest on loans that securities firms made to hedge funds and corporate borrowers was also included For some reason the Securities Industry Association, the source of these statistics, lumps interest and mergers and acquisitions fees together as “other securities-related revenues.” †16 Fees for underwriting stock and bond offerings were also becoming more important to the sell side But initial public offerings were not yet creating perverse incentives for buy-side firms not just to ignore but to abet bad research, as they would during the peak of the late 1990s boom More on this crucial topic in Chapter 10 *17 And yet it may be too simplistic to blame investment banking alone for the decline of research Much of the research that was so carefully and expensively produced before May Day was never read In a 1974 survey, institutional investors said they used only onequarter of the reports that brokerages sent them, and they thought less than 10 percent were worth paying for Investors bought research because they had to, not because they wanted to Even research that was as close to objective and unbiased as Wall Street could make it had a difficult time finding an audience In fact, sell-side research has an inherent flaw, rarely discussed but impossible to fix Investors use research reports for the same reason they use technical analysis or tea leaves: to make money And on Wall Street, information is valuable largely to the extent that it is proprietary But research, almost by definition, is public information Even in the 1970s the Dow Jones wire service would publicize new research reports soon after they were released Today, thanks to CNBC and the wires, any new information in a research report is available within minutes to everyone in the market, not just the clients of the firm that released the report It is almost impossible for sellside research to provide investors with a lasting informational edge “It takes a lot of time and work to just know what everybody else knows,” one analyst told the Times in an unintentionally revealing comment in 1985 “That’s where an analyst spends most of his time.” Of course, research reports aren’t just about information They’re about analysis But an analyst who has genuine insight into the future of the industry he covers can make more money on the buy side, as a hedge fund manager, than on the sell side At the peak of the 1990s bull market, top analysts made a few million dollars a year; top hedge fund managers made tens of millions Under those circumstances the best analysts have an almost irresistible incentive to leave the profession and start to run money for themselves If you really know where the gold is buried, why sell maps? Even into the late 1990s, Wall Street had a few genuinely superb analysts, men or women who did not want to run their own funds and enjoyed the visibility that the sell side offered But they were the exceptions The last firm of any size to provide old-school, untainted, pre–May Day–style research is Sanford C Bernstein, which does not have an investment banking division Bernstein’s research is notably different from that of the rest of the Street The firm’s “black books,” the staple of its research efforts, are short on quick tips and long on proprietary surveys and in-depth industry examinations And unlike mainstream firms, which distribute their research widely, Bernstein works to limit distribution of its books to the institutional investors who pay its bills In so doing, Bernstein fills a valuable niche, since even large mutual fund companies not want to spend the time or money that Bernstein does for its surveys Essentially, Bernstein works almost as a cooperative research service for the handful of big investors who are serious about understanding the stocks they own Demand for the high-quality research provided by Bernstein appears to be limited, however As the 1990s progressed, the firm’s influence slipped, and other efforts to launch major research-only firms sputtered Despite their complaints about the weakness of Wall Street research, institutional investors apparently have little interest in working to improve it Why should Fidelity Investments, the giant mutual fund company, demand better research from Merrill if Fidelity knows that Putnam Investments, its crosstown rival, will see the same reports it does? Fidelity is far better off trying to hire Merrill’s best analysts to manage its funds Economists have a catchy term for this problem: the tragedy of the commons So the demise of research was, in a way, inevitable Standard sell-side research is not worthless because it is bad It is bad because even at its best it has limited worth, at least for the sophisticated institutional investors who have the power to demand more High commissions hid that fact for a while; when they disappeared, research had to stand on its own, with unfortunate consequences *18 Basically, the more volatile the underlying stock and the longer the amount of time until the option expires, the more valuable the option Interest rates and dividends also factor in; higher rates and lower dividends make options more valuable †19 The later adjustment is somewhat complicated; it should probably be made to the balance sheet, not as a gain or loss on the income statement Otherwise all kinds of accounting madness are possible But accounting for the adjustment is a technical problem; the initial cost of the option is the fundamental issue *20 For example, suppose a company with million shares outstanding grants its employees million options (with a strike price of $10, the market price of the company’s stock) Over the next year the company’s stock jumps from $10 to $100, and its market value reaches $100 million The employees then exercise all their options, paying the company $10 million The company’s new value is $110 million—the $100 million plus the $10 million the employees have paid the company But instead of having million shares, the company now has million Instead of owning the whole company, the old shareholders own only half of it Employees own the other half Now, instead of being worth $100, each share is worth only $55 The company’s existing shareholders are $45 million poorer—their million shares, which were worth $100 million, are now worth $55 million That $45 million has gone to employees, who have paid $10 million for million shares worth $55 million The overall value of the company has not changed, but employees have taken part of it at the expense of shareholders *21 Ironically, federal income tax rules did recognize that options had a cost—companies could deduct their expense from their tax bills Thus options offered companies the best of both worlds, cutting taxes without affecting reported earnings *22 The successor to the Big Eight More on this in Chapter *23 It may be worth noting that companies and consultants routinely justify high pay for mediocre executives by arguing that they should make about as much as similar executives at their much more successful competitors Wide pay gaps are unfair and can demoralize executives, they say Take Bristol-Myers Squibb, an also-ran drug company in New York (How also-ran? By the time you read this, Bristol may no longer be independent.) In 2001, Bristol paid its outgoing chairman, Charles A Heimbold, almost $5 million, a $1.7 million raise, and gave him 736,000 options —in a year when Bristol’s stock fell almost 30 percent, far more than the average of other big drug companies Why the pay hike? “Mr Heimbold’s cash compensation [should] remain competitive with the compensation of chief executive officers with similar experience at peer group companies,” Bristol said in its proxy But that rationale apparently does not apply outside the executive suite Executives have no problem with paying themselves hundreds of times as much as their bottom-rung employees make Those gaps make sense because executives ultimately determine whether a company succeeds, the compensation experts say Well, which is it? If executives are truly vital to the success of their companies—and they probably are—then managers who make bad decisions should make far less than their winning counterparts High pay for high performance; low pay for low performance Over his nine years as chairman, William C Steere Jr built Pfizer into the world’s largest and most profitable drug company Perhaps he was worth the $17 million in pay and 800,000 stock options he received in 2000 But $17 million for Steere doesn’t justify $5 million for Heimbold, who built Bristol into a takeover target As it is, though, executives have it both ways, getting the rewards of power without its responsibilities *24 One of the most entertaining ironies of the CUC fraud is that no single individual lost more money because of it than Henry Silverman, the chairman of HFS Before the merger, HFS was a second-rate company with third-rate brands whose most important skill was accounting gimmickry; Silverman, a former investment banker, was—and remains—a top-rank pay pig In February 1998, just before Cendant crashed, he sold $55 million in stock (There is no evidence that he knew of the fraud at the time he sold.) After the crash, Silverman convinced his board of directors to allow him to trade twenty-five options that were far out of the money and unlikely ever to be valuable for 17 million options with much lower exercise prices Even if Cendant stock regained only half its losses, Silverman would make more than $100 million on his new options—while his shareholders remained under water Still, Silverman lost $800 million in paper wealth when Cendant’s stock collapsed after the fraud was revealed For years afterward he never missed an opportunity to whine about how CUC had deceived him “This is very painful, personally, professionally, and financially,” he said in June 2000 “We need closure.” Perhaps the $8.3 million in pay and million options Silverman received in 2000— a year when Cendant’s stock fell 60 percent—provided him with some relief *25 An important note on estimated losses: When numbers like $14 billion for Cendant or $80 billion for Enron or $150 billion for WorldCom are tossed around, take them with more than a grain of salt In one way they are real Cendant had 900 million shares outstanding, and each of those shares lost more than $15 in value on April 16, 1998 It’s therefore true that Cendant’s shareholders suffered a paper loss of $14 billion as the company’s stock fell, but the key phrase is paper loss Cendant’s investors, as a group, could never have cashed out all their shares for $30 billion even before the fraud was admitted If they had tried, Cendant’s stock would have fallen sharply, and they would not have received $30 billion From another point of view: It is not as if Cendant raised $30 billion from investors and then wasted that money, or as if the company’s executives sold $30 billion worth of stock they received from options In the years prior to the fraud, most Cendant investors were buying and selling shares from each other Many of those investors bought at a price lower than the $35 a share at which Cendant traded before it disclosed the fraud Yes, they suffered paper losses when the stock fell, but those were offset in part by their previous paper gains So how much money—how much cash—is really lost when a company’s stock falls after a fraud? The answer depends on how many shares it and its executives, have sold in the previous months and years, and at what price they were sold The $55 million Silverman raised by selling Cendant stock in February 1998 was money that came out of unsuspecting investors’ pockets, no two ways about it But $55 million is a long way from $14 billion I don’t mean to say that paper loss figures are totally irrelevant They are the simplest way to compare the scope of losses at different companies But be aware that comparing, say, the $150 billion loss suffered by WorldCom’s shareholders to the $150 billion federal budget deficit is misleading The deficit must be paid off dollar for dollar; WorldCom’s investors never really had $150 billion in cash to begin with *26 In September 2002, the Justice Department opened a new criminal investigation into Sunbeam’s activities during the time of Dunlap’s tenure at the company Better late than never *27 More on Levitt and the S.E.C in Chapter *28 In fact, some states once banned small investors from buying offerings that were “too expensive.” In 1980, for example, Massachusetts kept Apple Computer from selling shares to its residents Apple was trading at ninety times earnings; no company trading at more than twenty times earnings could be offered in the Bay State.1 *29 In the long run, Netscape would lose its battle with Microsoft; in 1997, its last full year as an independent company, it would lose $115 million In November 1998, Netscape agreed to be taken over by America Online for about $82 a share, adjusted for splits; an investor who bought on the first trade after the IPO and held until the takeover earned about 15 percent over three and a third years, an annual return of barely percent a year An investor who bought at the company’s December 1995 high would have lost more than half his investment But by then investors would have turned their attention from Netscape to newer and shinier tech stocks *30 To be sure, before the late 1990s big funds might not have cared about improving sell-side research (see Chapter 6), but that didn’t mean they wanted to pay for research that was patently useless *31 Magellan’s subpar returns were not the only reason Fidelity was disenchanted with Vinik; six months earlier he had publicly touted the merits of a couple of the technology companies in his portfolio as he was selling them But Magellan’s weak performance unquestionably played a part in Vinik’s downfall †32 The more the S&P gains, the wider the gap between its returns and cash, and the better a fund’s stock picks have to to keep the fund’s overall returns even with the index For example, if the S&P 500 rises 10 percent in a year and Treasury bills pay percent, a manager who holds 80 percent of his assets in stocks and 20 percent in cash had to pick stocks that rose 11.75 percent to produce a 10 percent return on his overall portfolio and match the S&P If the S&P rises 20 percent, the manager needs a 24.25 percent return on his stock picks just to match the S&P *33 In 2002, the S.E.C tightened the rules By 2006, companies will be required to file their 10-Ks no later than sixty days after the end of their fiscal year, and 10-Qs within thirty-five days of the end of a quarter †34 Shareholders should be wary of any company that routinely scrapes against the S.E.C.’s deadlines for filing reports, especially if it has announced its earnings months earlier Companies may file slowly in the hope of burying a telltale footnote or balance sheet item— or if they’re fighting their auditors for every penny of earnings A company that requests an extension is probably in serious trouble Since the S.E.C or Nasdaq often suspends trading in the stocks of companies that didn’t file on time, companies generally ask for extra time only if their books are in serious disarray *35 I’ll plead guilty here, too In March 2001, I wrote a column for the Times advising investors that it was “time to be greedy,” because prices had fallen so far in just a year Bull market habits are hard to break *36 For decades analysts had added back noncash amortization charges to a company’s net income to figure out its true earnings Goodwill is an asset that doesn’t really exist but is kept on a company’s balance sheet for accounting purposes Before 2002, companies had to “amortize” goodwill, or write it off over a period of years The amortization lowered reported earnings but had no effect on companies’ cash flow *37 Technically, by promising customers that it would give them software upgrades for free if it ever wrote new code, Computer Associates had created a potential liability whose cost couldn’t be measured until the contract had expired As a result, under accounting rules, it had to book revenues under a “pro rata” basis, a little at a time over the life of the contract The fact that Computer Associates had no intention of ever spending a dime on software upgrades was irrelevant *38 It may seem that I am quick to say that other reporters rely on short-sellers but don’t mention the help they give me In fact, I talk regularly to the shorts, including Chanos, and they have helped me many times But none of them was involved with the Computer Associates article; I stumbled across that story on my own *39 Whether or not that law passes, employees would be well advised to pretend that it has Putting a lot of your 401(k) in any one stock breaks the all-important rule of diversification Putting it in your own company’s stock is even worse You already rely on your employer for your paycheck; why double your dependence by betting your retirement on your company’s stock? If something goes wrong, your finances will be devastated *40 For the sake of simplicity, assume the loan is interest-free ACKNOWLEDGMENTS With thanks to: Ellen and Harvey, my parents Heather Schroder, my agent, who encouraged me from proposal to final draft Jonathan Karp, a wise and experienced editor Andrew Ross Sorkin, who offered keen suggestions on the first draft Jodie Allen, a friend in word and deed Matthew Kaminski, who read this manuscript at a time he had far more important things to worry about Winnie O’Kelley and Glenn Kramon, my editors at the Times, who gave me the time to write this book Floyd Norris and Gretchen Morgenson, who have seen everything on Wall Street and are always generous with their knowledge Chuck Hill of Thomson First Call, the master of financial statistics And a special thanks to the boys and girls of 4446 Finley, especially Nora and Matt, who looked the other way as I dug a hole in their couch —Written in Los Angeles, CA, and New York, NY ABOUT THE AUTHOR graduated from Yale University in 1994, with degrees in history and economics After working at The Denver Post and TheStreet.com, he joined The New York Times in 1999 as a business reporter specializing in financial investigative reporting He has three times been named one of the top thirty business reporters under the age of thirty He lives in New York City ALEX BERENSON Copyright © 2003 by Alex Berenson All rights reserved under International and Pan-American Copyright Conventions Published in the United States by Random House, Inc., New York RANDOM HOUSE and colophon are registered trademarks of Random House, Inc Library of Congress Cataloging-in-Publication Data Berenson, Alex The number: how the drive for quarterly earnings corrupted Wall Street and corporate America / Alex Berenson p cm Includes bibliographical references Corporations—Accounting—Corrupt practices—United States Corporations—Accounting—Corrupt practices—United States—Prevention Financial statements—United States—Auditing I Title HV6769 B467 2003 364.16'8—dc21 2002036950 Random House website address: www.atrandom.com eISBN: 978-1-58836-288-9 v3.0 ... Exxon and General Motors? They should, and they Every quarter they add up their sales and costs, and figure out where they stand Then they tell the world, in press releases and conference calls and. .. “Today, American markets enjoy the confidence of the world How many half-truths, and how much accounting sleight-of-hand, will it take to tarnish that faith?” But with the Nasdaq and Standard... 1982 The real answer requires a (brief) explanation of the history of accounting and Wall Street in the twentieth century, beginning with the boom and bust of the 1920s and the creation of the